Finite State Markov-chain Approximations to Highly Persistent Processes

The Rouwenhorst method of approximating stationary AR(1) processes has been overlooked by much of the literature despite having many desirable properties unmatched by other methods. In particular, we prove that it can match the conditional and unconditional mean and variance, and the first-order autocorrelation of any stationary AR(1) process. These properties make the Rouwenhorst method more reliable than others in approximating highly persistent processes and generating accurate model solutions. To illustrate this, we compare the performances of the Rouwenhorst method and four others in solving the stochastic growth model and an income fluctuation problem. We find that (i) the choice of approximation method can have a large impact on the computed model solutions, and (ii) the Rouwenhorst method is more robust than others with respect to variation in the persistence of the process, the number of points used in the discrete approximation and the procedure used to generate model statistics. (Copyright: Elsevier)